by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with the latest news on souring relations between the West and China.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including the latest on the Russia-Ukraine war and U.S. inflation and banking dynamics.

United States-China:  The House Select Committee on the Chinese Communist Party has been holding hearings and meetings on Wall Street this week to put further pressure on U.S. financial and business elites who have been reluctant to sever ties with China.  In a statement that we think investors should heed, the Republican chairman of the committee, Mike Gallagher of Wisconsin, and the Democratic vice-chairman, Raja Krishnamoorthi of Illinois, both said they favor new laws to restrict U.S. investment in publicly traded stocks and bonds of certain Chinese firms.

• The new legislation mentioned by Gallagher and Krishnamoorthi would go beyond the current U.S. restrictions on bilateral trade, investment, and technology flows, illustrating the risks to investors as U.S.-China geopolitical tensions worsen.
• As a reminder that China is also clamping down on bilateral business, the Chinese government today said it has “noticed reports” of “security incidents” related to iPhones made by U.S. technology giant Apple (AAPL, $176.30). The government emphasized that it is still committed to protecting the rights of foreign businesses and supporting free markets.  Nevertheless, since the statement followed so closely on Beijing’s recent directive which curbed the use of iPhones by certain government workers, it is being taken as a warning that China is prepared to undermine key U.S. economic interests to retaliate for the U.S. pushback.

European Union-China:  As advanced, low-cost electric vehicles from China start to flood Europe’s auto market, European Commission President von der Leyen today announced that she is launching an investigation into the subsidies paid to Chinese producers.  Complaining that European-made autos are often blocked from other markets, von der Leyen signaled Brussels will take a tough approach on subsidized Chinese EVs.

• The move is a reminder that von der Leyen and other leaders in Europe have swung behind the U.S. effort to push back against China’s growing geopolitical and economic aggressiveness.
• In response to von der Leyen’s speech, shares in high-flying Chinese EV companies have fallen sharply today, with Warren Buffett-invested BYD (BYDDY, $65.62) losing 2.8% of its value and rival Xpeng (XPEV, $18.65) losing about 2.5%.

United Kingdom-China:  Just days after British police said they had arrested two people, including a parliament researcher, on charges of spying for China, press reports say the authorities are preparing to arrest several more people in the coming months on charges that they have been secretly working to undermine Britain’s democracy under the direction of the Chinese government.  The news points to a further rupture in China-U.K. relations, which could potentially include new, U.S.-style restrictions on bilateral trade, investment, and technology flows.

Russia-North Korea-Ukraine:  Russian President Putin and North Korean Supreme Leader Kim met today at a Russian space-launch facility in Vladivostok, with both pledging to deepen their cooperation on security and economic issues.  The two leaders are widely expected to strike a deal under which North Korea will sell weaponry to Russia to help it continue its invasion of Ukraine.

• Separately, reports today say Ukrainian missiles struck a shipyard in Russian-occupied Crimea, heavily damaging or destroying two Russian navy vessels in drydock.
• The successful attack reflects how Ukraine’s military reach has been extended now that it has received long-range missiles from countries such as France and the U.K.

Sweden:  The center-right government this week proposed a 2024 budget that would hike military spending by approximately 28%.  The proposed budget would put Sweden on track to meet the North Atlantic Treaty Organization’s standard of spending at least 2% of gross domestic product on defense, even though the country is still waiting to be accepted into the alliance.

U.S. Military:  U.S. Air Force Secretary Kendall has announced that the service will miss its annual recruiting goal by about 10% when the fiscal year ends on September 30, marking the first such shortfall since 1999.  The deficit shows how most of the military is struggling to keep up troop levels because of factors such as the strong civilian job market, lingering disruptions from the coronavirus pandemic, and difficulties in finding enough young people who can meet today’s physical and intellectual standards.

U.S. On-Line Prices:  While investors today will focus on the headline Consumer Price Index (see U.S. Economic Releases below), a separate private index shows on-line prices are falling in year-over-year terms.  The Adobe Digital Price Index for August was down a full 3.2% from the same month one year earlier, including annual price declines of 7.3% for appliances, 7.0% for sporting goods, and 11.6% for electronics.

U.S. Banking Industry:  Incoming data shows net new bank lending has slowed to a crawl, with outstanding loans growing at an annualized, seasonally adjusted rate of just 3.6% so far in the third quarter, compared with average growth of about 7.0% over the long term.  Of course, part of the slowdown reflects weaker loan demand now that the Federal Reserve has hiked interest rates so aggressively since last year.  In addition, however, the slow growth reflects cautious lending as banks worry about rising deposit costs and asset values.  Importantly, slow lending could also help to finally push the economy into the recession that we’ve been expecting all year.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Today’s Comment opens with a discussion of new irritants in the China-India relationship and what they mean for investors.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including indications that the Bank of Japan could end its negative interest-rate policy by year’s end and signs of progress in the negotiations for new labor contracts in the U.S. auto industry.

India-China:  India yesterday imposed anti-dumping tariffs on some Chinese steel imports, responding to a flood of foreign steel and complaints from local producers in recent months.  From April through July, government data shows steel imports into India were up 23% from the same period one year earlier, with imports from China alone up 63%.  The anti-dumping duties are scheduled to last for five years.

• From China’s perspective, India’s new tariffs will only add to the growing list of irritants in the countries’ bilateral relationship. Some other irritants on that list include:
  • Territorial disputes, including fatal clashes, in the Himalaya mountains;
  • Increasing Indian support for the Philippines in its territorial dispute with China in the South China Sea;
  • Indian pressure on Sri Lanka to avoid allying too closely with China;
  • India’s growing participation in the U.S.-led “Quad” security grouping;
  • Indian restrictions on Chinese social media apps based on national security concerns; and
  • Recent efforts by Prime Minister Modi to establish India as the leader of the “Global South,” i.e., poorer countries in South Asia, South America, and Africa.
• Along with the recent reprimand that Chinese President Xi received from senior Communist Party leaders over his domestic and international performance, these irritants probably help explain why Xi declined to attend last weekend’s G20 meeting, which Modi hosted in New Delhi.
• In any case, it is clear that the China-India relationship is souring. To further peel India away from China and bring it closer to the U.S.-led bloc, Washington is likely to encourage that estrangement, including with economic incentives that could help make India more attractive for investors.  Nevertheless, our quantitative, objective methodology for assigning countries to the world’s evolving geopolitical and economic camps currently puts India in the “Leaning China” bloc, mostly because of India’s membership in the China-led Shanghai Cooperation Organization and its relatively modest trade relationship with the U.S. versus China.  India’s continued presence in our “Leaning China” bloc, at least for now, serves as a reminder that there could be delays and speed bumps before India swings more fully into the U.S.-led bloc.

Chinese Economy:  Two of the largest cities in Shandong province, China’s second-most populous region, said they have lifted their restrictions on home purchases.  That adds to the list of major local governments in China that have taken steps to boost their housing markets after being encouraged to do so by the central government.  Nevertheless, the piecemeal regulatory moves are widely viewed as insufficient to spark a significant improvement in home purchases or general economic growth.

Chinese Military:  Satellite imagery and social media posts show a large, nearly completed new drydock and basin at a major shipyard known for producing China’s top amphibious assault vessels.  The new facilities suggest Beijing has given the order to move forward with the construction of its massive, new Type 076 “landing helicopter docks.”  The new LHDs will be able to launch both helicopters and drones, aided by state-of-the-art electromagnetic catapults like those on China’s newest aircraft carrier and the U.S.’s new Gerald Ford-class carriers.

• Even though China already has the world’s largest navy, the new LHD program shows that Beijing intends to expand it further and increase its capabilities in preparation for a potential takeover of Taiwan and/or war with the U.S. On a related note, the Chinese navy today is launching its biggest-ever exercise with an aircraft carrier in the waters around Taiwan, the Philippines, and Guam.
• We continue to believe that China’s unceasing military buildup and modernization program will spark ever-greater concerns among Western officials, drowning out those business elites who argue for maintaining trade and investment ties with China. The result will be further risk for those who invest in companies based in China or who are dependent on the Chinese market.

Japan:  In a recent press interview, Bank of Japan Governor Ueda said his policymakers could be in a position to end their negative interest-rate policy by the end of the year, so long as there is continued growth in the country’s consumer prices and wage rates.  Coupled with the BOJ’s recent decision to allow longer-term bond yields to fluctuate more widely, the statement provides further confirmation that the policymakers are edging toward tighter monetary policy after years of extraordinarily loose policy.

• In response, the yield on longer-term Japanese government bonds has climbed smartly in recent days. The yield on the benchmark 10-year JGB yesterday closed at 0.705%, up from 0.589% one month ago and 0.251% one year ago.
• The value of the Japanese currency has also sharply appreciated. The JPY yesterday closed at 146.51 per dollar ($0.0068), for an appreciation of almost 1.0% from its level just one week ago.

United Kingdom:  In the three months ended in July, average wages excluding bonuses were up a record 7.8% year-over-year, while average total pay was up 8.5%.  The figures show British pay has now grown faster than the 6.8% rise in the consumer price index over the last year, which should boost consumer purchasing power and tempt the Bank of England to hike interest rates further.  On the other hand, the monetary policymakers will be concerned about a separate report today showing that in the three months to June, the value of residential mortgage in arrears was up a full 28.8% year-over-year, as rising interest rates put pressure on homeowners with floating-rate mortgages.

Libya:  Mediterranean Cyclone Daniel has devastated areas of coastal Libya, causing massive flooding and at least 5,000 deaths.  Libya is not a major economy, but the destruction could drive more Libyans toward migrating to Europe, potentially causing a new, politically divisive migration crisis in that important economy.

U.S. Bond Market:  New data from LSEG shows corporate bonds issued so far in 2023 will come due in an average of 10.0 years, marking the shortest average maturity in more than a decade.  The average maturity for investment-grade bonds has fallen to about 10.5 years, while the average for junk bonds has fallen to 6.0 years.  The shorter maturities suggest firms are betting that the Federal Reserve will soon be cutting interest rates.

U.S. Defense Industry:  As we’ve tracked rising U.S.-China tensions and resulting growth in U.S. defense budgets, we’ve noted that the relatively small, post-Cold War defense industrial base is bumping up against capacity constraints that are slowing the effort to rebuild allied defenses.  However, recent articles in Defense News illustrate how the Defense Department is helping address those problems.

• To accelerate the output of submarines, for example, the Navy since 2018 has spent some $2.3 billion on initiatives such as:
  • Promoting “strategic outsourcing,” which removes bottlenecks by shifting heavy subcomponent manufacturing out of the shipyards, and with those modules produced elsewhere, the shipyards can focus on final assembly, outfitting, and testing;
  • Providing funds to help expand and modernize the two existing shipyards that produce ballistic missile submarines and attack submarines; and
  • Expanding the supplier base by providing capital investment funds to smaller private firms so they can begin producing submarine-certified components.
• As these examples illustrate, the effort to expand the defense industrial base will help feed the re-industrialization of the U.S. economy that we’ve been writing about. As we’ve argued, re-industrialization will likely boost investment prospects in the industrial sector.

U.S. Auto Industry:  Automaker Stellantis (STLA, $18.69) said it has made progress in its negotiations for a new labor contract with the United Auto Workers, just days before the Thursday expiration of the current contract and the potential start of a disruptive strike.  The referenced progress probably relates, at least in part, to the company’s industry-leading offer of a 14.5% pay raise and the UAW’s modest cut in its demands to a pay hike of about 35%.  Still, UAW chief Shawn Fain complained that Stellantis and the other major automakers have waited until the last moment to make their economic offers, indicating he will keep up pressure on the firms in the hope of extracting large pay increases and other benefits.

Global Oil Market:  Fatih Birol, chief of the International Energy Agency, argues in an opinion article today that the world is coming to the end of the fossil fuel era, as the agency for the first time forecasts that global demand for petroleum oil, natural gas, and coal will peak before 2030.  According to Birol, the new, earlier forecast for peak consumption of fossil fuels can be attributed to the greater-than-expected investments in renewable energy projects over the last year.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Our Comment today opens with news about Chinese domestic politics and the country’s currency, the renminbi.  We next review a wide range of other international and U.S. developments with the potential to affect the financial markets today, including news of a cut in the European Union’s economic growth forecast and increased concerns about a potential federal government shutdown in the U.S.

Chinese Domestic Politics:  According to insider reports, influential Communist Party officials unexpectedly warned President Xi at their annual Beidaihe leadership retreat that if China’s political, economic, and social turmoil continues without any effective countermeasures being taken, the party could lose public support, posing a threat to its rule.  The reports say Xi was stunned by the reprimand and bitterly complained about it to his confidential advisors afterward.

• The reports could help explain why Xi failed to attend the Group of 20 (G20) summit in India over the weekend, why he missed a key speech at the recent BRICS summit, and why he appears to be backing away from a visit to the U.S. later this month.
• Rather than expressing his disdain for U.S.-founded international organizations, as pundits have suggested, Xi might be pulling back from such meetings to avoid being pressed on Chinese security and economic policies. In other words, Xi may have pulled back from these venues not for deliberate strategic reasons, but because of domestic political challenges.
• The reports serve as a reminder that Xi must still contend with domestic political pushback against his policies, even if he has done a good job solidifying his power. Going forward, that may force him to temper some of his policies and provide more stimulus to the economy despite his aim to rein in debt and control the private sector.
• All the same, other reporting suggests he is doubling down on at least some of his initiatives. In several recent speeches, for example, he has urged government officials to prepare for “worst case scenarios” and “extreme circumstances,” which some outsiders have interpreted to mean he is preparing for war with the U.S.

Chinese Economy:  The People’s Bank of China today issued a warning against speculating against the renminbi (CNY), saying PBOC officials “are capable of and feel confident in . . . keeping the renminbi exchange rate at a reasonably stable level.”  In response, the currency has rallied as much as 1.0% to 7.2698 per dollar ($0.1376).  Nevertheless, the renminbi is still trading close to a 16-year low as investors fret over China’s ongoing economic slowdown and worsening tensions with the West.

India:  As foreign investors sour on the Chinese economy, India is reportedly ramping up its infrastructure investment to increase its attractiveness as a place to do business.  For example, the country now has approximately 90,000 miles of national freeways, almost double the mileage one decade earlier.  The expansion and upgrading of India’s infrastructure will probably encourage even more foreign direct investment and portfolio investment.

Japan:  Another Asian country that appears to be benefiting from China’s malaise is Japan.  The Wall Street Journal today carries a useful examination of what’s been driving the Japanese stock market higher after many years in the doldrums.  Besides investors’ shift in focus away from China, the article cites positive developments such as improved corporate governance in the country, recent investments by Warren Buffett, and low valuations.

European Union:  The European Commission today cut its forecast for EU economic growth this year, saying it now expects gross domestic product to grow 0.8% in 2023, rather than the 1.0% it expected in May.  The Commission also said GDP will grow just 1.4% in 2024, down from 1.7% previously.

• The revised forecasts reflect headwinds such as high consumer price inflation and a big slowdown in German industrial output.
• Importantly, the new forecasts could help convince the European Central Bank’s policymakers to hold interest rates steady at their meeting on Thursday, rather than hiking them further in their continued fight against inflation.

United Kingdom-China:  In a bilateral meeting between British Prime Minister Sunak and Chinese Premier Li Qiang at the weekend’s G20 summit, Sunak said he personally expressed his “very strong concerns” to Li about China’s interference in the U.K.’s parliamentary democracy.  Sunak’s announcement followed news that British authorities in March arrested two men on charges related to spying for China.  One of those arrested was a long-time researcher in the U.K. parliament who had close contacts with Conservative Party politicians.

United States-Vietnam:  At their weekend summit, President Biden and Vietnamese leader Nguyễn Phú Trọng signed an agreement elevating their countries’ relationship to that of a “comprehensive strategic partnership.”  The agreement lays the groundwork for increased defense cooperation between the countries and establishes a joint semiconductor supply program to boost Vietnamese computer chip manufacturing in support of U.S. businesses.

• Previously, Vietnam had signed such strategic partnership agreements with only four other countries: China, Russia, India, and South Korea.
• The deal shows that China’s geopolitical aggressiveness in the South China Sea is pushing Vietnam into Washington’s embrace, just as it has done to the Philippines, and as it is likely to do to other countries in the Indo-Pacific region.
• Based on our objective methodology for assigning countries to the world’s evolving geopolitical and economic blocs, we currently assess Vietnam to be in the “Neutral” bloc. For example, note that even as Vietnam tiptoes into a closer relationship with the U.S., it is also continuing to seek weapon imports from Russia to build its defense capability against China.  However, if Washington and Hanoi continue to cooperate more closely, Vietnam could eventually shift to the “Leaning U.S.” camp, or even to the “U.S.-led bloc.”

United States-Venezuela:  Rumors that secret talks between Washington and Caracas will lead to détente and reduced economic restrictions have given a boost to Venezuelan bonds recently.  Although the debt still trades at a tiny fraction of its face value, the hope of renewed cross-border investment has pushed the value of the benchmark 2027 bond up above 10 cents on the dollar.

U.S. Household Wealth:  Data from the Federal Reserve shows the net worth of U.S. households and nonprofits rose to a record $154.3 trillion in the second quarter, driven about equally by the rebound in stock prices and rising real estate values.  The rise in net worth comes despite moderating economic growth and concerns about an impending recession.

U.S. Labor Market:  The United Auto Workers union continues to negotiate for a new labor contract with the top three U.S. automakers—Ford (F, $12.30), General Motors (GM, $32.95), and Stellantis NV (STLA, $18.23)—with the current contract expiring Thursday night at midnight.  In simplistic terms, the auto manufacturers want to channel much of their recent profits into new electric vehicles, but the union, with new leverage because of labor shortages, wants them to share their proceeds with employees to make up for significant concessions they granted over the last decade.

U.S. Policymaking:  The House of Representatives is back in session this week after its summer recess, and all eyes are on the increasing frictions between Speaker McCarthy and the right wing of his Republican Party.  The increasing acrimony has raised concerns about a destabilizing leadership battle and the possibility of a partial shutdown of the federal government.  Such a shutdown could happen if the right-wing of McCarthy’s party prevents passage of the appropriations bills needed to fund the government once the current fiscal year ends on September 30.  Coming just as more pandemic stimulus programs are set to end (including the moratorium on student loan payments and subsidies for childcare centers), a government shutdown could help to finally push the economy into the long-expected recession.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will be broken down into three sections: 1) Why more central banks are signaling an end to their tightening cycle; 2) How the no-shows by the U.S. and China reflect the waning relevance of multilateral organizations; and 3) Our thoughts on the leader widely expected to succeed AMLO as the president of Mexico.

Peaking Trend: The Bank of Canada has become the first G-7 central bank to signal that it may be nearing the end of its hiking cycle.

• Bank of Canada Governor Tiff Macklem said that policymakers are nearing success in their battle against inflation. The dovish comments come a day after Canadian policymakers agreed to hold rates steady at 5%. Although inflation remains well above the central bank’s 2% target at 3.3%, the bank’s governor’s change in tone suggests that the policymakers are shifting their stance. This comes amid signs that the labor market is easing, with the unemployment rate increasing for four consecutive months from 5.0% to 5.5%. The bank has said that it is willing to take further action if needed to bring inflation under control.
• His remarks come as other G-7 central banks are set to meet to discuss their latest policy decisions. The European Central Bank (ECB) has signaled that it is prepared to raise its benchmark interest rate one last time this year, possibly in September, while the Bank of England (BOE) has said that its policy rate is “near the top of the cycle.” Meanwhile, the Federal Reserve is divided on whether more needs to be done to combat inflation, with some officials advocating for one more hike and others hinting that rates are high enough.

• The world is witnessing a change in monetary policy, with central banks potentially opting for holding rates steady or even cutting them. The Central Bank of Brazil has become the first notable central bank to reverse course on interest rates, cutting them in August for the first time since 2020. This move is likely to be followed by other central banks in the coming months, as global growth shows signs of slowing down. Nevertheless, inflation still remains significantly higher than the targets set by central banks. As a result, the process of easing policy may be more gradual than what investors are accustomed to, as central banks strive to strike a delicate balance between managing the risks of inflation and recession.

Choosing Sides:  The G20 and ASEAN summits wrap up this week with key absences, as prominent world leaders chose not to attend.

• Chinese President Xi Jinping’s absence from the ASEAN and G20 summits is a notable snub, suggesting that he is becoming increasingly disinclined to engage with countries that do not share China’s worldview. His absence from the G20 is particularly significant, as he has not missed a meeting of the group in over 10 years. This suggests that Xi is cooling on the G20, or at least on the current format of the group. Xi’s replacement at the ASEAN summit, Premier Li Qiang, used the platform to warn countries against taking sides in what he described as a “new Cold War.” China’s recent actions are a clear sign that it is concerned about the growing international pressure and is seeking to isolate itself from groups that do not support its policies.
• Meanwhile, U.S. President Joe Biden’s absence from the ASEAN summit unnerved some countries and is likely a reflection of his view that the group has not been effective in achieving its goals. The ASEAN declaration states that the group strives to ensure “durable peace, stability, and shared prosperity” in Southeast Asia. However, Myanmar’s military coup and its continued participation in the ASEAN summit are in direct contradiction to this aim. Instead of traveling to Jakarta for the ASEAN summit, Biden will travel to Hanoi, Vietnam, to sign a “comprehensive strategic partnership.” The President’s decision to travel to Vietnam instead of attending the ASEAN summit suggests that he is more interested in building closer relationships with individual countries than with large groups of nations.

• We believe the world will be split into two camps: the BRICS countries and the G7 countries. The chart above shows that the BRICS countries have been growing at a faster rate than their G7 counterparts since the onset of the pandemic.
• The decision by the two leaders to skip summits could be seen as a sign of the declining relevance of multilateral organizations. These organizations have often been used to get countries together to resolve their differences. However, recently, they have been seen as being biased towards either the United States or China. The lack of a neutral forum for countries to have dialogue and to prevent the further deterioration of relations raises the likelihood of conflict in the future. At this time, we do not believe that tensions have reached a level that warrants serious concern, but we are monitoring tensions between the U.S. and China closely.

AMLO’s Successor: The Mexican president has chosen his replacement for after his tenure ends in 2024.

• Mexico’s ruling party, the National Regeneration Movement (MORENA), has nominated Claudia Sheinbaum, the former mayor of Mexico City, as its candidate for the 2024 presidential election. Sheinbaum’s close relationship with current President Andrés Manuel López Obrador (AMLO) makes her a strong contender to become the country’s first female president. The opposition coalition Frente Amplio por México has chosen Xóchitl Gálvez as its candidate. Current polls show that Sheinbaum leads Gálvez by 17 percentage points, making her the heavy favorite to win the presidency. Sheinbaum has promoted herself as a continuity candidate of her predecessor and has promised to crack down on corruption, increase cash transfers to the poor, and improve the country’s energy sovereignty.
• Despite the global slowdown, Mexico’s economy has seen robust growth in recent months. In the first quarter of 2023, the country expanded at an annual rate of 3.4%, outpacing the growth rates of the United States (2.1%) and the European Area (0.5%). This impressive performance is due to a number of factors, including strong consumption, a surge in exports to the United States, and an inflow of investment from companies looking to build supply chains closer to the U.S. to mitigate disruptions from abroad. Additionally, the Mexican peso (MXN) has been one of the best-performing currencies in the world, which has mitigated inflationary pressures within the region.

• The biggest question about a Sheinbaum presidency is whether she will be able to establish herself as her own political figure, independent of Andrés Manuel López Obrador. With approval ratings above 60%, it is widely believed that AMLO will try to maintain his influence on the party behind the scenes. The main difference between Sheinbaum and her predecessor is that she supports a transition to nationally subsidized renewable energy, while AMLO favors propping up Mexico’s oil industry. That said, they both agree on the need to protect Mexico’s lithium resources from privatization.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning! Today’s Comment will be broken down into three sections: 1) How the rising U.S. dollar is impacting other countries; 2) How political fracturing in Spain and Brazil is representative of a global trend; and 3) What trade and investment flow data says about the U.S.-China relationship.

Dollar Soaring: The U.S. dollar hit its highest level in six months on Wednesday in a troubling sign for global currencies.

• Investors are flocking to the dollar as a safe haven currency, attracted by the U.S. economy’s resilience in the face of global economic headwinds. The latest Institute for Supply Management (ISM) non-manufacturing index unexpectedly rose from 52.7 to 54.5 in August, beating expectations of 52.5. Similarly, last week’s employment data also exceeded expectations, with the U.S. economy adding 187,000 jobs in July, slightly above projections of 174,000. The better-than-expected numbers have led to speculation that the Federal Reserve will favor at least one more rate hike before the end of the year.
• In contrast, Europe and China are experiencing more signs of economic slowdown in their respective regions. Private sector surveys showed that service activity in China expanded at its slowest pace in eight months in August, while business activity in Europe fell deeper into contraction territory. The divergence in growth expectations has weighed on their respective currencies, with the EUR hitting a three-month low and the Chinese yuan (CNY) falling to its lowest against the USD since December 2007. As a result, policymakers at the European Central Bank and People’s Bank of China are likely to use more aggressive policies to prevent further depreciation.

• Central bankers are in a difficult spot. The strengthening dollar is expected to worsen price pressures related to rising commodity prices. On Wednesday, oil prices hit $90 a barrel for the first time in 2023 after Saudi Arabia and Russia agreed to extend voluntary production and export cuts. The combination of a strong dollar and rising commodity prices will likely weigh on global growth by making it more expensive for governments to repay dollar-denominated debt and import energy. As a result, central bankers may be less willing to provide stimulus, which could further dampen economic activity.

Unusual Coalition: Embattled leaders in Spain and Brazil make unsavory deals to stay in power.

• Spanish Prime Minister Pedro Sánchez is considering granting amnesty to Catalan separatists in exchange for their support in forming a government, but only if they also agree to back key legislation over the next four years. Talks between the two sides have not yet begun, but Sánchez’s party is working on a stability pact with the Junts per Catalunya party. If successful, this would allow Sánchez to remain in power. Still, he risks alienating some of his base who are uncomfortable with his perceived concessions to separatist groups within the country. Hence, his party popularity may take a hit.
• Brazilian President Luiz Inácio Lula da Silva reached a deal with the right-wing Progressistas (Progressive) and Republicanos (Republican) parties to secure their support for his agenda. In exchange for the support of these two parties, Lula agreed to give up two seats in his cabinet. The pact is estimated to expand Lula’s support from 250 deputies to 320 out of a possible 513. The growing coalition should make it easier for him to push through difficult legislation such as tax reform. However, there is hope that conservative members of his coalition will be able to check his more radical proposals.
• Political polarization has caused gridlock in the legislatures of Spain, Brazil, and other countries around the world. This has made it difficult to pass legislation, leading to inaction on important issues and the rise of extremism. Situations such as the 2023 attack on the Brazilian Congress and the Catalan Independence referendum in 2017 are examples of how toxic politics have become over the last decade. Although markets sometimes perform well in this environment as the inertia reduces uncertainty about a sudden change in policy, the fragmentation of the electorate suggests that this is not sustainable in the long term, particularly in emerging markets.

 Sino-American Divorce: Economic data for the United States and China shows the two are going their separate ways.

• The latest phone developed by Huawei (002502, CNY, 2.57), the Mate 60 Pro, has led to concerns that China has been able to circumnavigate export bans. The phone caught the eye of U.S. regulators as it was able to download at faster speeds than many of the top 5G phones on the market, including the Apple’s (AAPL, $177.20) iPhone 14 Pro. This has raised questions about whether Huawei has been able to obtain components from American companies in violation of the export bans, as it was widely believed that its Chinese semiconductor producer SMIC (0981, HKD, 19.82) is not known for its advanced chip-making capabilities. In an attempt to get more Chinese consumers to buy phones made domestically, Beijing has banned the use of the iPhone for Government workers.
• Frictions between the two largest economies have started to impact trade and capital flows. In July, the annual change in American imports of Chinese goods fell to its lowest since 2006. Additionally, Chinese companies have started to reduce foreign direct investment (FDI) into the U.S. and instead invest in countries with access to U.S. markets, such as South Korea and Mexico. In 2022, Chinese inflows into the U.S. fell to the lowest level since 2009. At the same time, the U.S. government is trying to restrict American investment in Chinese companies, particularly those linked with strategic ties to Beijing’s military.

• The shifting trade and capital flows between China and the United States highlight the intention of the two countries to reduce their economic dependency on one another. As mentioned in previous reports, we do not expect this to happen quickly, but rather gradually over the next few years. This process will likely be beneficial for countries that have exposure to both China and the United States, such as Mexico and South Korea mentioned previously, but also could include countries such as India, Vietnam, and Indonesia.

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by Patrick Fearon-Hernandez, CFA, and Thomas Wash

[Posted: 9:30 AM EDT] | PDF

Good morning.  Risk markets are under pressure again this morning, with rising Treasury yields raising investor fears.  Rising interest rates are also lifting the dollar.  The JPY is challenging recent lows, and traders are watching for central bank intervention.

In today’s Comment, we start our coverage with a roundup of economic factors.  Up next is our international overview, followed by news on the war in Ukraine.

 Economic Roundup:  The Fed looks set to pause, and a government shutdown may be looming.

• Fed Governor Waller was on CNBC yesterday and signaled that the FOMC was likely to “proceed carefully,” suggesting the committee will stand pat at the next meetings, scheduled for September 19 and 20. Currently, fed funds futures are projecting with near certainty that the policy rate will be held steady.  We also note these futures are leaning toward steady policy from here, although with much less conviction.  Waller tends to lean hawkish, so his remarks are probably a solid signal of steady policy.
  • Although there is ample evidence that the FOMC isn’t united on the future path of policy, Chair Powell has a remarkable ability to forge a consensus on policy. In fact, he has the best track record for the fewest dissents of all the Fed chairs in the post-Treasury agreement era.  The table below shows the chairs since 1951 and the number of dissents divided by the number of meetings over which each chair presided.  By far and away, Powell has been able to create consensus on the FOMC when compared to his predecessors.  It’s hard to know his secret; it’s possible that the members during his tenure have been simply less combative, although that would be hard to determine.  We will have a better understanding five years from now when the full meeting transcripts are released.  In general, policy dissents would be expected to increase volatility.  So, in this regard, Powell is probably, in a small way, holding down market uncertainty.

• Congress is set to name Phillip Jefferson as vice-chair of the Federal Reserve. Although widely expected, Jefferson is likely to lean dovish and thus will give the dovish members of the FOMC more influence.
• Congress averted a shutdown last spring, but it’s starting to look like it will be hard to avoid one later this month. Speaker McCarthy is struggling to move his caucus to a budget deal and probably can’t pass a budget without Democratic support.  McCarthy is trying to keep the government open, and hold his position as speaker, a pair of goals that is looking increasingly tenuous.  Government shutdowns tend to lower bond yields as spending stops and the Treasury reduces its borrowing.  However, coming on the back of recent downgrades, a shutdown now might have a different outcome.
• This has been the summer of labor unrest, as several large companies are either facing the threat of strikes or have decided to capitulate to their unions. The Biden administration finds itself in a difficult spot as these negotiations unfold.  On the one hand, the president fashions himself as a friend of labor, but on the other, strikes in key industries will hurt the economy and massive contract gains could spark inflation.  The president is running for re-election and wants to avoid both a downturn and another spike in price levels.  Thus, the White House is mostly staying out of the contract fights.  Although this is one way to avoid the dilemma we outlined above, it won’t necessarily help him with union voters.
• Although yearly apartment rental rates are in a clear downtrend, the overall number doesn’t capture suburban versus city costs. Reports suggest that suburban rental rates are soaring.

• Announcements from Saudi Arabia and Russia indicating that they will maintain production cuts through year’s end sent oil prices higher. The rise in oil prices, coupled with lingering logistical issues caused by the war in Ukraine, are raising diesel prices which then tend to filter into goods prices.
• As U.S. bank regulators are spinning out new regulations, especially on bank capital, American lenders are looking with envy at Europe. European regulators are taking a lighter touch with their banking system.
• As pandemic savings are exhausted, households are increasing their use of credit cards. Delinquencies on credit cards and auto loans are moving higher.  The expected recession from policy tightening has been avoided so far, in part, because the economy has become less sensitive to interest rates.  However, we may be starting to see evidence that elevated interest rates are having a detrimental effect.
• Japanese investors, fearful of inflation, are increasing gold purchases.
• Europe is implementing new regulations on technology platform providers. The Digital Markets Act will force tech providers to allow more competition on their platforms, reduce data collection by the platforms, and provide companies operating on the platforms easier access to their customer’s data.  The tech firms are not pleased.

 International Roundup:  The defense industry is globalizing and there is a race to gain access to Pacific islands.

• With the growing U.S. aversion to free trade deals, there is a concern that it may be difficult for Washington to build alliances to isolate the Russia/China/Iran axis. Allowing allies to run trade surpluses with the U.S. was a key element in America’s alliance system that isolated the Soviet bloc during the Cold War.  Because such policies are politically untenable at present, we have been closely watching to see if policymakers can create an alternative to trade.  It appears that globalizing supply chains for military spending is becoming one substitute.  As nations begin to rebuild their militaries, the U.S. is “friend-shoring” production to create a broader supply chain.
• China’s anti-access/area denial (A2/AD) strategy is designed to prevent the U.S from moving expensive naval assets into close proximity to a military theater. China has designed missiles and expanded its submarine force to counter U.S. aircraft carriers as part of this strategy.  One way to respond to China’s strategy is to put bases on islands and other land masses around China.  Last week, we noted that the U.S. was recommissioning mothballed facilities in Asia for this purpose.  At the same time, Beijing won’t passively allow the U.S. to engage in this policy.  On Monday, Vanuatu established a new government following a no-confidence vote.  The new PM, Sato Kilman, replaces Ishmael Kalsakau, and is thought to be more friendly to China than his predecessor.  We expect China and the U.S. to actively woo these Pacific nations for defense purposes.
• As Commerce Secretary Raimondo began her visit to China, Huawei (002502, CNY, 2.65) unveiled its new 5G smart phone, a device that apparently houses semiconductor chips that the U.S. is trying to prevent China from acquiring. The announcement was pointed, suggesting that U.S. efforts to restrict China’s access had failed.  In the wake of this announcement, the U.S. is “seeking information” and may add new sanctions.
• In what is being called a mistake, President Biden is not going to the ASEAN meetings next week, sending VP Harris instead as his replacement. If Washington’s goal is to woo Asian nations to the U.S.’s “side,” such no-shows make little sense.  What hurts the optics is that the president is making visits to Vietnam and India.  However, we also note that President Xi is not going to the G-20 meeting in New Delhi, so perhaps we are seeing unforced errors on both sides.
• Southern Europe is facing a deluge, with record rains causing widespread flooding.

War in Ukraine:  The slow offensive may be gathering speed and Russia “woos” Cubans.

• Ukrainian sources suggest that the entrenchments the Ukrainian military is facing are not as strong as what they dealt with initially. The Russians, in anticipation of the offensive, built extensive fortifications, but these comments indicate that progress may be underway.  SoS Blinken is traveling to Kyiv this week and is expected to offer an additional $1.0 billion in aid.
• Cuba has uncovered a trafficking ring, where Russians are trying to encourage Cubans to fight in Ukraine. Havana is not pleased with this development.
• Oil and gas rigs in the Black Sea are becoming targets in the conflict. Given the already tight supplies, this development is another bullish factor for oil and gas prices.
• Kim Jong-un is visiting Russia, with the expectation that Moscow wants to source military equipment from the Hermit Kingdom.  Pyongyang is said to be seeking missile and nuclear warhead technology.  Washington has warned North Korea that it will “pay a price” for cooperating with Russia.  However, given how heavily sanctioned Pyongyang is already, it’s hard to see what additional measures could be implemented.

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